Making Sense of Bank Reform

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Two years after the fall of Lehman Brothers, the immense overhaul of the banking system is just beginning, and it is far too early for companies to breathe a collective sigh of relief. The banking system is safer — but not by a lot. Banks now have larger capital buffers, and the complex collateralized debt obligations (CDOs) that wrought so much destruction are nearly extinct. Yet 11% of retail banks remain at risk of failure, says the Federal Deposit Insurance Corp. (FDIC).

The passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act represents not a regulatory finish line so much as the firing of a starter’s pistol that will kick off a marathon of rule-making and second-guessing. Key questions remain about how much reform will come to pass, when, and what it will ultimately mean for companies. “Regulation is always in catch-up mode — there’s no way around it,” says Cory Gunderson, managing director of the U.S. financial services and global risk and compliance practices at Protiviti.

As for what has been settled and what hasn’t, three key areas of uncertainty deserve watching: whether public bailouts of megabanks can be avoided in the future, what regulators have done to return commercial lending to normal, and whether Wall Street has been reined in too much, too little, or just enough.

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Dodd-Frank created the Financial Stability Oversight Council, a mandated team of traditionally autonomous financial regulators who now are expected to work together to ensure that the financial system does not develop pockets of dangerous dependency. The group, which held its first meeting last month, has the daunting goal (given recent history) of eliminating “expectations on the part of shareholders, creditors, and counterparties of [large banks] that the government will shield them from losses in the event of failure,” the U.S. Treasury says.

Dodd-Frank attempts to ensure that by imposing greater regulatory supervision on bank holding companies with assets greater than $50 billion. It also requires nonbank financial firms and systemically important firms within the next 18 months to develop plans for rapid, orderly unwinding of their businesses in cases of severe financial distress. But will this and any of the other proposed measures prevent the U.S. government from lavishing taxpayer funds on failed banks and being the arbiter of which banks fail and which get life-saving injections of capital?

Sandy Brown, a partner at Bracewell & Giuliani who served at the Office of the Comptroller of the Currency in the 1980s, is skeptical that the “too big to fail” problem can be solved. “There are certain organizations that are so important to the national and global economy that, if they were to fail, it would set off a massive crisis,” he says.

Rehabilitating Main Street

The fallout from mismanaged credit risk by retail banks is still being felt. Forty-one U.S. banks went into FDIC receivership in the third quarter. The FDIC says it is cracking down by retraining its staff in the fundamental tenets of credit reviews and loan-concentration evaluations, expanding bank examiners’ authority to comprehensively scrutinize the scope of a bank’s risk-taking, and determining how to downgrade a bank’s CAMELS rating (capital adequacy, asset quality, management quality, earnings, liquidity, sensitivity to market risk) in a speedier fashion. The agency is also subjecting newly chartered banks to higher capital requirements, frequent examinations early on, and tight controls over material changes to start-ups’ business plans.

The aggressiveness of banking regulators rankles some banking executives and their clients, however. When examiners force more write-downs of existing loans and require large reserves to cover possible loan losses, banks’ credit committees tighten their underwriting. “Regulators are so critical of loans that banks are not going to make any new ones,” says Brown. A CFO survey found that 69% of finance executives thought stricter rules on capital, leverage, and liquidity would increase their banking costs or negatively affect their access to capital (see “The Calm Before Reform,” October).

Kurt Woerpel, finance chief of Potomac Supply, a provider of forest products to homebuilders, says the banks he talks to are closed for business. Potomac was forced to switch banks and change its funding from a cash flow–based loan to an asset-backed one when its previous lender cut its exposure to Potomac’s industry. “Banks are increasingly concerned about their decisions and evaluations being second-guessed,” Woerpel says.

Even with this additional scrutiny, the rebuilding of customer confidence in commercial banks is still unfinished. In late September, the FDIC proposed a rule extending deposit insurance on noninterest-bearing transaction accounts — like business checking — until the end of 2012. How long and to what extent the government will have to backstop retail banks’ liabilities remains an unanswered question.

Reining in Wall Street

On Wall Street, meanwhile, a chastened industry has undergone a level of self-correction. “The market continues to favor less-complicated [instruments],” says Joel Telpner, a financial transaction attorney at Jones Day. “There is no appetite for truly complex CDOs with all kinds of synthetic bells and whistles.”

But regulators still have yeoman’s work to do addressing the lack of transparency and dangerous amounts of leverage. Precrisis, regulators didn’t have the means to spot the kinds of exposure AIG had in over-the-counter sales of credit default swaps, for example. “If there had been reporting and disclosure requirements to government regulators and the market, natural market forces would have precluded AIG from engaging in that level of derivatives trading,” says Telpner. “Counterparties didn’t have the ability to see the universe of trades AIG was engaged in.”

CFOs seem more sanguine about reforms in this area. Only 15% thought tighter regulation of over-the-counter derivatives would increase their finance costs or limit their access to capital. Daniel Goldsmith, finance chief at insurance brokerage Hub International, says he welcomes more disclosure and doesn’t see it as a sea change. The company buys forward contracts to hedge Canadian currency exposures as well as interest rate swaps. “Those instruments can be in a position where you owe money, and we’ve always recorded that and looked at it as a liability,” he says.

Will banking be sturdier by the time the next crisis arrives? Dodd-Frank defers many decisions until some 60-plus studies and 94 reports are completed, so finance chiefs will be learning about the implications of the law for years to come.

There is one truth about financial-market regulations that companies need to recognize: “Regulators are akin to referees — they can chase the ball and influence the game, but in the end the players decide the outcome,” says Protiviti’s Gunderson. The most important work in preventing or minimizing the impact of the next crisis could be taking place in boardrooms and on management floors, says Gunderson.